Elec­tion risks to fis­cal ad­just­ment mod­est

Less than a day ahead of the gen­eral elec­tion, the out­come is still un­cer­tain. Opin­ion polls sug­gest that the elec­tion is likely to re­sult in a hung par­lia­ment with no sin­gle party hav­ing a ma­jor­ity, rais­ing the prospect of a sec­ond elec­tion be­fore the end of the year.

Nei­ther the Con­ser­va­tives nor Labour have es­tab­lished a con­clu­sive lead in the opin­ion polls (both around 33.5% each on av­er­age), while the Lib­eral Democrats have seen their po­si­tion decline to 8% from 23% in 2010. More­over, the ris­ing sup­port for the Scot­tish Na­tional Party (SNP) fol­low­ing last year’s in­de­pen­dence ref­er­en­dum and for the Eu­roskep­tic In­de­pen­dence Party (UKIP) pose in­creas­ing chal­lenges for the main par­ties, po­ten­tially de­priv­ing them of key seats in the elec­tion. Based on cur­rent opin­ion polls, the SNP looks to be­come the third largest party in the UK, likely to win up to 56 seats lo­cated solely in Scot­land. By con­trast, de­spite its visibility in the opin­ion polls, UKIP could win fewer than five seats.

The decline in sup­port for the three main­stream par­ties and the ris­ing pop­u­lar­ity of the al­ter­na­tive par­ties makes the out­come less pre­dictable than in 2010. Based on cur­rent pro­jec­tions of seats in par­lia­ment, DBRS’s cur­rent view is that the most likely out­comes are a mi­nor­ity sin­gle party gov­ern­ment (Con­ser­va­tives 280 seats or Labour 270 seats) or a mi­nor­ity coali­tion (Con­ser­va­tives with the Lib­eral Democrats 27 seats, or Labour with the Lib­eral Democrats with ex­ter­nal sup­port from the SNP 47 seats). A Labour coali­tion that in­cluded the SNP is cur­rently un­likely, but not im­pos­si­ble as it could con­trib­ute to a ma­jor­ity coali­tion.

How­ever, nei­ther a pe­riod of po­lit­i­cal un­cer­tainty fol­low­ing the elec­tions, nor the com­po­si­tion of the next gov­ern­ment would likely af­fect DBRS’ AAA Sta­ble sovereign rat­ings on the UK. All three ma­jor par­ties share a con­sen­sus in favour of fis­cal con­sol­i­da­tion, even if the ap­proach and pace dif­fer to some ex­tent. More­over, the ro­bust fis­cal frame­work in place and the over­sight by the in­de­pen­dent Of­fice for Bud­get Re­spon­si­bil­ity (OBR) cre­ate size­able con­straints against fis­cal loos­en­ing.

A pe­riod of mod­er­ate un­cer­tainty seems likely fol­low­ing the elec­tion if cross-party ne­go­ti­a­tions are re­quired be­fore a gov­ern­ment can be formed and a set of pol­icy pri­or­i­ties agreed upon. From a pol­icy per­spec­tive, DBRS does not ex­pect a sub­stan­tial de­vi­a­tion from the cur­rent fis­cal pol­icy stance. All three ma­jor par­ties likely to be part of any coali­tion or mi­nor­ity gov­ern­ment re­main com­mit­ted to a multi-year fis­cal con­sol­i­da­tion pro­gramme.

The strong cross-party sup­port for the Char­ter for Bud­get Re­spon­si­bil­ity, which was passed into law in mid-Jan­uary means that the Con­ser­va­tives,

Labour and Lib­eral Democrats have sim­i­lar fis­cal tar­gets. Th­ese are: (i) a cycli­cally ad­justed cur­rent bal­ance on a rolling three-year hori­zon and (ii) a fall­ing debt-to-GDP ra­tio in 2016-2017. Th­ese fis­cal tar­gets are sim­i­lar to those of the cur­rent coali­tion and would, if ad­hered to, be suf­fi­cient to put the debt to GDP ra­tio on a steady down­ward trend over the medium term.

In the 2015 Bud­get, the OBR es­ti­mated that the in­cum­bent coali­tion’s fis­cal plans would tighten pol­icy by 5% of GDP over five years. This would put the debt-to-GDP ra­tio on a down­ward trend, fall­ing to 81.4% in 2019-2020 from 88.8% in 2015-2016, and would turn the cycli­cally ad­justed cur­rent bal­ance from a deficit of 2.2% of GDP into a sur­plus of 2.1% of GDP in 2019-2020. Th­ese plans are in ex­cess of the Char­ter for Bud­get Re­spon­si­bil­ity (CBR) tar­gets, which only re­quire a zero cycli­cally ad­justed cur­rent bal­ance deficit, not a large sur­plus.

The main dif­fer­ence be­tween the three main par­ties over fis­cal pol­icy would likely rest with the size, the pace of the con­sol­i­da­tion and the com­po­si­tion of the ex­pen­di­ture cuts and in­creases in taxes. The Con­ser­va­tives have pledged to elim­i­nate the deficit by 2018-2019, largely through de­part­men­tal spend­ing cuts and wel­fare spend­ing re­duc­tions with no ma­jor tax hikes. Labour and the Lib­eral Democrats have also com­mit­ted to fis­cal con­sol­i­da­tion and aim to meet the CBR tar­gets, but not to over-achieve.

Labour, in par­tic­u­lar, ad­vo­cated a fis­cally neu­tral mix of a higher tax bur­den (im­pos­ing a tax on ex­pen­sive prop­er­ties, rais­ing the top rate of in­come tax, and in­creas­ing the tax on the bank­ing sec­tor) and ad­di­tional spend­ing. The Labour plan may trans­late into a tar­get for a cycli­cally ad­justed cur­rent sur­plus of 0.5% of GDP, con­sis­tent with the CBR tar­gets, al­low­ing for ex­tra spend­ing from 2017-2018 on­wards ver­sus the Bud­get plans. As a re­sult, a Labour-led gov­ern­ment would need to tighten fis­cal pol­icy by 2.5% to 3% of GDP in the first three years af­ter the elec­tion (sim­i­lar to the coali­tion’s cur­rent plans), with a neu­tral stance there­after.

An elec­tion out­come that re­sults in a greater role for the SNP in the UK gov­ern­ment could well re­new con­cerns about the po­ten­tial for a break-up of the UK. An in­creased SNP role could em­bolden those who favour in­de­pen­dence for Scot­land. At the same time, it could ex­ac­er­bate un­ease in Eng­land over the role of Scot­tish MPs in gov­ern­ing English af­fairs and the per­ceived fis­cal im­pact of de­vo­lu­tion. Over time, such pres­sure com­ing from both sides could put more mo­men­tum be­hind Scot­tish in­de­pen­dence.

More­over, dis­cus­sion of EU membership could ex­ac­er­bate such ten­sions.

A Con­ser­va­tive-led ma­jor­ity gov­ern­ment would raise the risk of an even­tual de­par­ture from the EU be­cause it would be com­mit­ted to hold a ref­er­en­dum by the end of 2017. Whether the ref­er­en­dum yields a yes or no vote will cru­cially de­pend on how a Con­ser­va­tive-led gov­ern­ment man­ages to rene­go­ti­ate con­di­tions of the UK’s membership in a num­ber of pol­icy ar­eas prior to the ref­er­en­dum. Th­ese in­clude: en­hanc­ing com­pet­i­tive­ness through less reg­u­la­tion, pol­icy flex­i­bil­ity through opt-out rules, re­turn­ing power to mem­ber states, and im­mi­gra­tion pol­icy changes. If rene­go­ti­a­tions are suc­cess­ful, the gov­ern­ment could present the re­sults to the Bri­tish elec­torate and sup­port con­tin­ued membership of the EU.

Over the medium-term, the reper­cus­sions for the UK from leav­ing the EU would partly hinge on what al­ter­na­tive trade agree­ments the UK could ne­go­ti­ate bi­lat­er­ally with the EU. With the UK im­port­ing more from the EU than it ex­ports, and UK GDP worth 14% of to­tal Euro­pean GDP, DBRS ex­pects that the UK would suc­ceed in ne­go­ti­at­ing a new set­tle­ment that repli­cates at least part of cur­rent trade ar­range­ments. How­ever, not reach­ing such a set­tle­ment would ad­versely im­pact busi­ness in­vest­ment and growth prospects with po­ten­tially neg­a­tive im­pli­ca­tions for DBRS’ sovereign rat­ings on the UK.